walking wounded or living dead? making banks foreclose bad loans max bruche and gerard llobet...

Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans

Max Bruche and Gerard Llobet

discussed by:Ulrich Hege (HEC Paris)

U Vienna/ÖNB/CEPR • Oct. 3, 2011

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Living Dead Distortion

Distressed banks inefficiently avoid liquidating projects if it triggers their demise, as continuing creates uncertainty and increases prob. of survival

Failure to liquidate akin to risk-shifting

Private info. on θ, random payoff ε Given liabilities D, distortion arises for high θ

bang-bang decision on continuation/liquidation, as usual

Regulator’s challenge: propose optimal mechanism

two part tariff s(θ), F(θ) generally implements optimal mechanism Uli Hege – Comments on Bruche and Llobet

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Countervailing Incentives and Optimal Solution

Because of countervailing incentives, mechanism can squeeze information rents to zero

incentive to overstate θ to get higher transfer s(θ), to understate θ to avoid high fixed payment F(θ)

useful in particular from ex ante perspective, to avoid distortions in screening incentives (but see comment)

Authors carefully discuss many extensions: foreclosure of good projects, imposing losses on debt holders, Also: private info on ε, deposit guarantees and

social cost to bank failure, signal effect to depositors if bank participates, time-varying recovery rates or costs of bank funds

Uli Hege – Comments on Bruche and Llobet

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Some Short-cuts

Some issues are not addressed in the model, or only informally (many acknowledged by authors):

they consider only long-term funding (no maturity transformation)

banks have no informational advantage about the size of the shock

no discussion of optimal entry point of regulation: as it stands, mechanism implemented at all times, with optional participation, like a “buyback window”

high informational demand on regulator, especially when accounting for time variability and bank heterogeneity


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Banks …

… once in distress, are explosive


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Comments: Optimality

Is the mechanism first best? It isn’t:

Bank owners expect an ex ante gain from the living dead distortion. They keep this rent even when the scheme is implemented – so there is an ex ante distortion

it adds to existing bailout bias (e.g., Kelly, Lustig & Van Nieuwerburgh, 2011)

Worst banks issue (θ > θ*): because T(θ) is convex, regulator finds that including types θ > θ* into scheme is too expensive – that is, the ex post worst banks. Will they be left alone.


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The Balanced Budget Issue

Mechanism contains no balanced budget condition for regulator. It “may” run deficit

In equilibrium, the regulator will always run a deficit:

debt holders gain, equity holders are neutral, so the mechanism will subsidize the debt holder’s gain

It will be impossible to expropriate depositors

We do not know how large the expected budget shortfall would be. Some skepticism seems in order


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An Alternative

Bruche-Llobet mechanism pertains to banks in distress, i.e. no or little value of bank equity left

Alternative: regulator takes over banks in distress, does resolution on its own (taxpayers’) account

call it nationalization requires some information on distress (signal on

θ)

That is, idealized FDIC-style bank resolution: Once sign of distress appear, bank swiftly taken

over, restructure (sell and liquidate assets) no guarantee for bank creditors beyond deposit

guarantees (fka deposit insurance), unlike many bank nationalizations of late

no evidence that private resolution works betterUli Hege – Comments on Bruche and Llobet

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Horse Race: Comparing Two Mechanisms

Bruche-Llobet Nationalize

Optimal liquidation incentives for bad projects (with E[ε] < ρ ) Y Y

Truthful revelation of θ without information rent Y N

Avoid ex ante distortion on bank equity value N Y

Address the worst banks (θ > θ*) N Y

Optimal continuation/liquidation decision for all projects, incl. those with E[ε] > ρ

? Y

Asymmetric info advantage of banks

N / ?(“yes, if buy back”)

Y


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Relevance

How important is the living dead distortion? Theoretical argument perfectly sound: distressed banks

have an incentive to gamble

Example Japan. But little other examples. Counterexample: US home foreclosures.

Thoughts why its importance may be exaggerated: only relevant if there are important holes in bailout put short-term funding, reduces risk-shifting incentives

(Barnea, Haugen, and Senbet, 1980) for non-distressed banks, the distortion goes the other

way round: if a non-performing loan can be liquidated, doing so is rational even if socially inefficient (“paradox of puttable debt”)

(regulatory) capital constraints and liquidity constraints will force banks to liquidate assets


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Unintended Consequences

Imagine Bruche-Llobet becomes law; some of the likely problems to arise:

Ex ante risk-shifting incentives likely exacerbated: banks’ equity rents from living dead distortion preserved. Plus now they will survive for sure !

The θ > θ* problem: leaving the worst banks alone most likely not credible - or if it is, mechanism will distort the distribution of θ that banks target

In general, the hold-up , idiosyncratic and systemic, issues the political economy of banking. Uli Hege – Comments on Bruche and Llobet

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Conclusion

Very elegant and rigorous analysis, clear proposal

Nice find that information rents can be avoided, and discussion of regulatory benefits

Real effort to add extensions and discuss model limitations

Still, proposal best locked away in hard-to-reach outlet


walking wounded or living dead? making banks foreclose bad loans max bruche and gerard llobet...

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